It’s the weekend before the big strategy meeting, and a 150-page document, plus appendices, lands in your in-box—as a pre-read. You sigh. As the CEO, you know all too well how this will play out.
On Monday morning, the presenter starts with a market outlook and competitive overview. Someone asks a question about page 5. “We will cover that on page 42,” the presenter might say—knowing it’s unlikely he will get to page 42 before the meeting ends. Or he may answer, “We have considered that, and there’s an extensive appendix on exactly that point.” Or: “Good question! Let’s take that offline.” In strategy meetings, presenters tend to deflect as many questions as they can, trying to move to the last page as smoothly as possible so they can get that all-important “yes” to the plan, “yes” to the request for resources, “yes” to a shot at the next promotion.
Peter Drucker famously said that “culture eats strategy for breakfast.” Nowhere is that more evident than in the strategy room, where egos and competing agendas, biases and social games reign. The budget process intervenes, too. You may be discussing a five-year strategy, but everyone knows that what really matters is the first-year budget. So most managers try to secure resources for the coming year while deferring accountability for results as far as possible into the future.
One outcome of these dynamics is the hockey stick projection, confidently showing future success after the all-too-familiar dip based on the first year’s investment. Yet, more often than not, this projection fails to materialize, leading to a new hockey-stick strategy being proposed the following year.
“about 50 percent of your position on the curve is driven by your industry—highlighting just how critical the ‘where to play’ choice is in strategy.”
CEOs can reset the strategy process and tame the social dynamics with data. We examined publicly available information on dozens of variables for the world’s 2,393 largest corporations between 2010 and 2014, and found the levers that explain more than 80 percent of the up-drift and down-drift in corporate performance. Our goal was to develop an objective, external benchmark that will enable CEOs to assess a strategy’s odds of success before they leave the strategy room, much less start to execute the plan.
THE ODDS OF STRATEGY
The starting point for developing such a benchmark is embracing the fact that business strategy, at its heart, is about beating the market. Economic profit—the total profit after the cost of capital is subtracted—measures a company’s success at this by showing what is left after the forces of competition have played out.
Plotting the average economic profit for each company demonstrates a power law—the tails of the curve rise and fall at exponential rates, with long flatlands in the middle.
The power curve reveals a number of important insights that are key to CEOs’ decisions:
1. Market forces are pretty efficient. For companies in the middle, the market takes a heavy toll. These firms delivered economic profits averaging just $47 million a year.
2. The curve is extremely steep at the bookends. Companies in the top quintile capture nearly 90 percent of the economic profit created. At the other end of the curve, the undersea canyon of losses is deep—though not quite as deep as the mountain is high.
3. The curve is getting steeper. Back in 2000-2004, companies in the top quintile captured a collective $186 billion in economic profit. Fast forward a decade and the top quintile earned $684 billion. A similar pattern emerges at the bottom. Since investors seek out companies that offer market-beating returns, capital tends to flow to the top, no matter the geographic or industry boundaries.
4. Size isn’t everything, but it isn’t nothing, either. Economic profit reflects the strength of a strategy based not only on the power of its economic formula but also on how scalable that formula is. Compare Walmart, with a moderate 12 percent return on capital but a whopping $136 billion of invested capital, with Starbucks, which has a huge 50 percent return on capital but is limited by being in a much less scalable category. They both generated enormous value, but the difference in economic profit is substantial: $5.3 billion for Walmart versus $1.1 billion for Starbucks.
5. Industry matters, a lot. Our analysis shows that about 50 percent of your position on the curve is driven by your industry—highlighting just how critical the “where to play” choice is in strategy. Industry performance also follows a Power Curve, with the same hanging tail and high leading peak. The role of industry in a company’s performance is so substantial that you’d rather be an average company in a great industry than a great company in an average industry.
6. Mobility is possible—but rare. Here is a number that’s worth mulling: the odds of a company moving from the middle quintiles of the Power Curve to the top over a 10-year period are 8 percent. That means just 1-in-12 companies make such a leap.
When you realize that success is largely defined by your company’s and your industry’s movements on the Power Curve, your perspective changes. Your horizon broadens. You’re no longer comparing yourself with last year’s results or your closest rivals, but with the full universe of companies competing for capital and economic profits.
Success for your strategy becomes about moving up on the Power Curve, and your main competitor is the Darwinist force of the market that squeezes your profitability. In the end, it’s you versus the world.